How to start a financial crisis in Russia

Starting a financial crisis is a bit like starting a house fire. It involves four basic steps: take away the fire extinguishers, douse the place in petrol, light a match, and retreat to a safe distance.

Removing the fire extinguishers is the logical first step. There's not much point starting a fire if it can be put out before it gets going. In the context of a financial crisis, this means removing Russia's access to its foreign exchange reserves, and stopping it from getting more.

"Foreign exchange reserves" refers to a country's stockpile of foreign currencies. They are vital for stopping a financial crisis. If investors start fleeing a country, that country's currency falls in value. This makes it much more expensive to import the things businesses and households need to do business and, more alarmingly, it causes any debts that are denominated in a foreign currency to get very large very quickly. This can cause the banks, businesses or households which hold those foreign debts to default, triggering rolling crises across the economy.

Governments are very aware of this risk. This is why the governments of countries which have foreign-denominated debts (usually developing countries, since it is cheaper for them to borrow in foreign currencies than their own) hold lots of foreign exchange reserves. If investors start fleeing, they use these reserves to buy their own currencies to stop their currency from falling and to stop a crisis from starting.

Russia is one of those countries. It has $US630 billion in foreign exchange reserves. It's been accumulating these reserves for many years to try to make its economy less vulnerable to Western sanctions. Russian authorities, however, have made a big and rather embarrassing mistake: they've misunderstood the difference between "ownership" and "control".

Even though Russia owns hundreds of billions in foreign exchange reserves, its government only controls a fraction of them. Russian authorities foolishly invested those reserves in international assets, which are mostly controlled by the West, to try and make money. This fact has not gone unnoticed. The West, led by the United States, has promptly frozen those assets. Russia's available foreign exchange reserves plummeted by 60 per cent, severely limiting its ability to protect its currency and ward off a financial crisis.

Of course, stopping Russia from accessing its foreign exchange reserves is only one piece of the puzzle. You also need to stop it from getting more.

Russia gets its foreign currencies from exporting things to other countries - primarily gas and other resources. It can access emergency foreign exchange reserves through the IMF, through a currency swap arrangement with China, through a $US100 billion bailout fund with the "BRICS" countries (Brazil, Russia, India, China and South Africa) and by selling its 2300 tonnes of gold or other state-owned assets.

These sources of foreign exchange need to be cut off if the West is to create maximum pressure on Russia's financial system. The US government controls the IMF, so that's easy, and its measures to block purchases of gas and resources, freeze assets and block sales will make it hard for Russia to sell goods, services and assets. The biggest challenge is China, followed by India, who could provide Russia with foreign exchange through the bailout fund, through a bilateral currency swap line, or by buying Russian exports and assets. Getting China and India to keep their wallets in their pockets will be key.

Overall, the West is doing pretty well on the first step for creating a financial crisis in Russia. But it's not doing as well on the second step: throwing as much fuel around as possible.

To trigger a currency crisis, the West needs to make it as easy as possible for Russian businesses and households to get their money out of Russia, so as to push the currency into freefall. But many of the West's actions are doing the opposite, by making it harder for Russians to get their money out of the country. Calls to prevent Russians from buying Bitcoin, for example, are the complete opposite of what we should be doing. The more money that gets out, the bigger the currency crisis.

The West is doing better in triggering a banking crisis. It has blocked access for many Russian banks to the SWIFT system - the system used for international payments. This makes it difficult for these banks to borrow internationally to build their buffers, should Russians start withdrawing their savings. Only some Russian banks have been excluded so far. Ramping this up will create more pressure on Russia's banking system.

Blocking access to foreign exchange and making it easier for people to get their money out of Russia will trigger higher interest rates in Russia, which have already surpassed 20 per cent. This is the key ingredient for triggering a debt crisis, as it becomes increasingly difficult for banks, businesses, and households to service their debts.

The third step for creating a financial crisis - throwing the match - is ironically being supplied by President Putin himself. The economic objective here is to undermine confidence in the currency, banks, and Russian assets to encourage people to run. Threats of nuclear war, breaches of ceasefires, incoherent media appearances, and threats of long-term consequences for the West are excellent ways to throw a match onto the pile of financial fuel. Any lingering doubts about whether Putin has any credibility as a geopolitical strategist should have now been dashed.

The final step for creating a financial crisis - retreating to a safe distance - raises the most important question of all: should we do it? Having the ability to trigger a financial crisis in Russia does not necessarily mean it's a good idea. Is there such a thing as a "safe distance" in a globally interconnected world? Should we be playing games with the lives and livelihoods of the Russian people, the majority of whom oppose this war? What is our objective in creating a financial crisis in Russia in the first place?

There will definitely be spillovers from a Russian crisis for the rest of the world. By definition, if the Russian economy is globally connected enough that the West can trigger a crisis in it, then it is also globally connected enough to send spillovers to the rest of the world. The rest of the world will see energy prices rise, inflationary pressures escalate, and investors flee to America. Developing countries' exchange rates will tank, creating financial stability risks. International banks, businesses and investors might get caught in the crossfire. Some might scale back lending and investment to avoid the risk.

The Russian people will be hit the hardest. Financial crises hurt the poorest of society the most. Is it worth the pain? The objective of Western sanctions is to push Putin to end the war sooner, to stop him from advancing further, and to send a clear signal to other rogue actors that invasions of neighbours will be met with co-ordinated retaliation. The goal of creating pain for Russians domestically through sanctions that were promised well in advance is to encourage them to pass that pressure onto Putin. The fact that an increasingly frazzled Putin has referred to these sanctions as being "akin to a declaration of war" suggests it's working.